“High external debt, and low reserves continue to make Sri Lanka vulnerable to external shocks. Other rating constraints on Sri Lanka include the high general government net debt burden (at 74.9 percent of GDP in 2016),” S & P said.

“There are risks to our baseline expectation of declining public debt as a percentage of GDP. In particular, an estimated 43 percent of Sri Lanka’s high stock of central government debt is denominated in foreign currency. That means any significant exchange rate depreciation would again put public debt on a rising trajectory.”

“We may revise the outlook back to stable if Sri Lanka’s external and fiscal indicators continue to improve, or if we conclude that the nascent strengthening of Sri Lanka’s institutions and governance practices is on a more sustainable footing.”

The full statement follows

Sri Lanka ‘B+/B’ Ratings Affirmed; Outlook Remains Negative

OVERVIEW

• The Sri Lankan government’s reform efforts and the IMF lending program have led to nascent improvements in the country’s fiscal profile.
• We are therefore affirming our ‘B+/B’ sovereign credit ratings on Sri Lanka.
• The outlook remains negative, however, given Sri Lanka’s weak external profile, in particular, its low net reserve levels, and the vulnerability of public finances to any exchange rate shocks.

RATING ACTION

On March 7, 2017, S&P Global Ratings affirmed its ‘B+’ long-term and ‘B’ short-term sovereign credit ratings on the Democratic Socialist Republic of Sri Lanka. The outlook on the long-term rating remains negative. We also left our transfer and convertibility risk assessment on Sri Lanka unchanged at ‘B+’.

RATIONALE

Over the past year, Sri Lanka’s fiscal position has improved as a result of government-led reforms and IMF technical and funding assistance. However, high external debt, and low reserves continue to make Sri Lanka vulnerable to external shocks, in our opinion. Other rating constraints on Sri Lanka include the high general government net debt burden (at 74.9% of GDP in 2016).

Nevertheless, the average maturity of the general government debt profile at approximately seven years is unusually long compared with other emerging market peers’.

With GDP per capita estimated at US$3,911 (2016), Sri Lanka’s level of prosperity is low. The authorities, moreover, continue to face significant challenges in effectively addressing structural imbalances due to institutional constraints and a fragmented political landscape. These rating constraints weigh against Sri Lanka’s sound growth potential, which speaks to strengths in the garment, tourism, and business process outsourcing sectors.

During 2017-2020, we expect fiscal consolidation to reduce borrowing further.

We project annual growth in general government debt to average 4.4% of GDP for 2017-2020, versus an average of 7.0% annually from 2014-2016. In view of Sri Lanka’s robust nominal GDP growth, we project net general government debt to decline to 65% of GDP through 2020, assuming currency stability versus the dollar (and hence a degree of real exchange rate appreciation).

At the same time, we expect only slow progress in reducing debt-servicing costs, which we estimate to account for more than 37% of government revenue in 2017. This is the third-highest ratio among all 131 sovereigns that S&P Global Ratings currently rates, trailing only Lebanon and Egypt(see “Sovereign Risk Indicators,” published Dec. 14, 2016; a free interactive version is available at spratings.com/sri).

There are risks to our baseline expectation of declining public debt as a percentage of GDP. In particular, an estimated 43% of Sri Lanka’s high stock of central government debt is denominated in foreign currency. That means any significant exchange rate depreciation would again put public debt on a rising trajectory.

We consider exchange rate stability will, therefore, remain a major priority for Sri Lanka’s policymakers and its central bank, limiting monetary flexibility. If all of Sri Lanka’s public debt were denominated in its own currency, this would not be a rating constraint.

Sri Lanka’s external liquidity position has stabilized over the past year, and should be bolstered by support from the IMF. However, Sri Lanka’s external metrics are still beset by the following weaknesses:

• We estimate Sri Lanka’s usable international reserves were US$3.0 billion as of January 2017, which represents less than two months’ coverage of current account payments. These reserves include drawings on currency-swap facilities of US$700 million with the Reserve Bank of India (RBI), introduced in March 2016.

• We forecast the trade deficit to amount to 9.3% of GDP in 2017, a slight improvement from an estimated 10.0% in 2016. While the regulatory regime has been re-calibrated to discourage overwhelming demand for vehicle imports, strong domestic consumption and a robust investment outlook will keep Sri Lanka’s structural trade deficit in place.

• Our projection of net current transfers–mostly workers’ remittances, of which more than half come from the Gulf states–suggests much slower growth than in previous years, in line with broad weakness in the source countries’ economies.

We expect external liquidity (measured by gross external financing needs as a percentage of current account receipts [CAR] plus usable reserves) to average 123% over 2017-2020, compared with 116% in 2015-2016. We also forecast that the country’s external debt (net of official reserves and financial sector external assets) will average 160% of CAR from 2017-2020, a notable deterioration from 136% in 2015.

Securing external liquidity support from the IMF has eased the aforementioned external pressures for the time being. We believe the attendant risks could be further mitigated by allowing the Sri Lankan rupee to float more freely.

Although the Central Bank of Sri Lanka (CBSL) has increasingly spoken in favor of a freely floating rupee in recent months, this has yet to manifest in substantially higher reserves. One structural factor in favor of Sri Lanka’s external stability is its low banking sector external borrowings.

The gaps we observe in Sri Lanka’s policymaking capacity partly reflect the political uncertainty associated with deeply-rooted factionalism within the government. We believe this hinders responsiveness and predictability in policymaking and weighs particularly on business confidence, investment plans, and overall growth prospects.

Elsewhere, we believe that the CBSL’s ability to sustain economic growth while attenuating economic or financial shocks continues to improve. Although the CBSL is not independent of other policymaking institutions, the central bank is building a record of credibility, shown in reducing inflation through the use of market-based instruments to conduct monetary policy, as well as the planned introduction of an inflation-targeting regime.

Sri Lanka’s growth outlook continues to be underpinned by government investment (including rebuilding the war-torn northern districts), rising tourist arrivals, and moderate inflation, which we expect to remain in the single digits.

We expect Sri Lanka’s growth prospects to remain favorable. We believe the country will most likely maintain growth in real per capita GDP of 4.5% per year over 2017-2020 (equivalent to 5.2% real GDP growth). Stronger growth, in our view, would require improved institutional settings and a pick-up in export markets.

Combining our view of Sri Lanka’s state-owned enterprises and its small financial system (banks’ loans to the private sector account for only about a third of GDP), we view the government’s contingent liabilities as limited.

OUTLOOK

The negative outlook indicates that we could lower our rating on Sri Lanka in the next 12 months if (1) we see signs of a reversal in reform momentum,

We may revise the outlook back to stable if Sri Lanka’s external and fiscal indicators continue to improve, or if we conclude that the nascent strengthening of Sri Lanka’s institutions and governance practices is on a more sustainable footing.

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